When people think of how to invest their money they usually think of buying bonds, preferred shares, or common shares but rarely do they think of investing in the bank loans of that same company. The idea of investing in bank loans is not well understood as it is a fairly recent development in the Canadian market and yet it can be very attractive.
Well established companies have access to a variety of sources of capital. To raise equity they can issue common or preferred shares in the market. If they want to borrow money, they borrow from the bank and when they are large enough, they can issue bonds in the market.
Types of Bank Loans
There are different types of bank loans. The revolving loan is one that can be drawn down and repaid several times throughout the period much like an individual’s line of credit. Then there are the term loans. They are drawn down at the beginning and then are repaid over a fixed period. Once a payment is made on a term loan it cannot be re-borrowed. For companies with very large borrowing needs, generally in excess of $100 million or more, banks will often syndicate their loans. This means the loan is shared by a group of banks so that no one bank has too much exposure to just one company. Starting in the mid 1990s in the US and later in Canada, the Term Loan B market developed. This is an institutional market for buying and selling pieces of a term bank loan. Term Loan Bs are widely held as they trade in fairly small increments (sometimes as small as $1 million) and there is an active secondary market for buying and selling these loans after they have been issued. Retail investors cannot buy Term Loan B loans directly, however, there are pooled and mutual funds as well as ETFs that invest in this particular type of loan.
Why Bank Loans?
There are reasons you might prefer to buy a bank loan over a bond of the same issuer. First of all, the interest rate on a bank loan is reset periodically, usually every three months. If you think rates are going to rise, you would prefer to have your interest rate reset rather than being fixed for the entire term of the loan. Most bonds have a fixed interest rate that does not reset during the term. Secondly, bank loans often are secured by the company’s assets whereas many bonds are unsecured. If the company has difficulty repaying their debt down the road, those assets can be sold and the proceeds used to repay part or all of the bank loans. As a result, your recovery on the loan is much higher than if you have no security.
There is still credit risk with bank loans, just as there is with bonds, and so it is very important to make sure that when you look for a bond fund or ETF, the manager has the skill to weed out the good from the bad.